Armanino Blog

Out-of-Compliance Policies Can Be Costly

by Scott Copeland
June 15, 2012

Before you sell equipment or patent rights to a company affiliate, think twice about the price. With revenue-hungry governments worldwide looking to keep their tax bases strong, many are stepping up enforcement on transfer pricing.

Manufacturers that don’t follow the rules can be taxed twice on transactions, and face hefty penalties to boot. If your company has multiple entities that buy and sell from one another, now is the time to review your transfer pricing policies.

What is Transfer Pricing?
“Transfer pricing” refers to the price that related parties, such as divisions of a company, charge one another for goods or services. These include tangible goods, services, intangible property, interest on loans and other financial transactions.

Transfer pricing piques the interest of tax authorities because it affects the amount of taxable profits for each division of a company. Because taxes vary from country to country, a company theoretically could slash its tax burden by transferring income to another division in a lower tax bracket. A U.S. dress manufacturer, for example, could buy dresses from its plant in Malaysia, where taxes are lower, at artificially high prices to reduce its taxable income in the United States. Transfer pricing laws prohibit these transactions from occurring to ensure that each country gets its fair share of tax revenue.

Most countries have the authority to adjust the price of transactions between companies in their jurisdictions and foreign entities. This makes transfer pricing a hot issue for multinational manufacturers. Even manufacturers whose operations are within U.S. borders need to handle transfer pricing carefully, though, because the United States can adjust prices between domestic related parties.

Is the Transaction at “Arm’s Length?”
Countries generally require transactions between related parties to meet an “arm’s-length” standard, which means the price is comparable to what it would have been if the parties weren’t related. When comparing pricing for a transaction to similar transactions between unrelated parties, consider all applicable conditions, including the geographic market, related warranties and other terms of sale. Because comparable transactions can be difficult to find, particularly for intellectual property or other intangible goods, the resulting arm’s-length standard often is a range of prices, rather than a specific price.


There are several methods to test whether prices meet an arm’s-length standard. The United States and the Organisation for Economic Co-operation and Development, a Paris-based organization of 34 countries that issues global transfer pricing guidelines, require companies to use the method that produces the most reliable results. This means that companies may have to use more than one test to determine the correct pricing. In addition to transactional methods, companies can use profitability methods, which base appropriate pricing on the profit levels of similar companies in similar industries.

A growing number of countries, including the United States, China, India and Italy, require companies to prepare transfer pricing studies that show the basis behind their pricing. And after manufacturers prepare their studies, they need to stick to them — tax authorities will penalize companies whose actual pricing for transactions differs substantially from the pricing included in their studies.

Is an Audit in your Future?
Even if your company follows all transfer pricing rules, you may still be subject to an audit of your transfer pricing practices. Common audit triggers include a lack of documentation; large transactions; royalties or payments for intangible goods; operating losses, particularly multiyear losses; large year-to-year shifts in the level of profits or losses; transactions with related parties in low-tax countries; and a low effective tax rate compared with gross revenue.

The key to surviving an audit is having the appropriate transfer pricing documentation in place before the authorities come knocking. A transfer price study is one of the first things the IRS asks for during the audit, and while it takes several months to complete one correctly, the IRS typically wants it in 30 days.

If a government decides that the price you charged or paid to a related party was inappropriate, it will adjust the price and tax you on the difference — meaning you pay tax on income that your related party already paid tax on as well. Manufacturers that don’t have required transfer pricing studies in place also are subject to penalties, which can be as much as 40% of the additional tax assessed in the United States.

Play by the Rules
If your company has multiple entities that buy and sell from one another, review your transfer pricing policies to ensure they’re in compliance. If you’re on the right side of transfer pricing laws, you’ll avoid having your profits gobbled up by audit costs and penalties.


Is an advance pricing agreement right for you?

With stepped-up scrutiny on transfer pricing, many manufacturers are minimizing their risk by entering into advance pricing agreements (APAs). These agreements, entered into by tax authorities and companies, set agreed-upon prices for related-party transactions, virtually eliminating the risk of documentation-related penalties or double taxation. Manufacturers also can resolve pending pricing disputes by instituting an APA, which can be applied retroactively to pricing from previous years.

An APA most often is multilateral — that is, it covers your dealings with the IRS as well as the tax authorities in the other countries where you do business. The agreements typically are valid for several years.

Creating an APA can be time-consuming and expensive. Is it worth your time and trouble to negotiate an APA? The answer may be yes if:

  • You’re involved in complicated or unusual related-party transactions,
  • You regularly complete related-party transactions of intellectual property or other intangible goods,
  • You use uncommon methods for determining “arm’s-length” pricing,
  • You’re already being audited for transfer pricing, or
  • You’re risk-averse.

    June 15, 2012

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    Scott Copeland - Partner-in-Charge, Audit - San Francisco CA | Armanino
    Partner-In-Charge of Audit
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